Time to Switch Into European Equities?

Analysts tend to start each year optimistically. 2010, 2011 and 2012 all saw an upbeat start to the year for global stock markets. 2013 is hailed by many equity strategists as the start of the long-anticipated "great rotation", with investors moving into stocks out of bonds, ending the reign of the bond bull market in recent years.

But it's European stocks that are being seen as particularly investable.

BlackRock has seen a marked increase in flows towards European equities.

"These flows initially came from cash and U.S. equities but also more recently from some investors switching out of bonds. The latter is very significant as it is the first time we have seen this for many years," Nigel Bolton, head of the European Equity Team at BlackRock wrote in the firm's "Barometer for 2013".

The U.S. fiscal cliff and debt ceiling uncertainties have shifted the focus of investors' worries from the euro zone to the U.S., and highlighted the valuation discount of European equities relative to their U.S. peers.

According to BlackRock, European stocks are trading at a 25 percent discount to the U.S. equity market. That's close to the highest historic discount, which typically stands at 8 percent on average, BlackRock said.

The turning point for European stocks was the summer of 2012, when investors' portfolios had a record underweight position in Europe equities, and the European Central Bank (ECB) finally announced it would do everything it could to keep the euro zone together. The ECB's intervention triggered a rally in European stocks in the second half of 2012. But, according to Nigel Bolton, "we are only mid-way through a bull market."

BlackRock says, on a price-to-earnings basis, European stocks are still around 15 percent below their historic long-term average, and it sees encouraging signs such as the setting up of the euro zone's permanent bailout fund, called the European Stability Mechanism.

"The European Stability Mechanism is now de facto funded, given ECB support, ensuring that any country in need of it will be bailed out. Reforms in Italy and Spain are continuing apace," Bolton said.

But risks remain and the key questions for 2013 are whether a pro-reform government will be elected in Italy, whether Germany will keep its pro-euro zone stance in the election campaign, and whether Spain will need a formal bail out.

These milestones could provide some volatility, but if there is no slippage in political actions, BlackRock's analysts see returns of 15 percent on European stocks in 2013.

"The European equity market offers an earnings yield of 9 percent and a dividend yield of 4 percent - significantly more attractive than the lower yields investors currently achieve on cash or on low-risk sovereign bonds."